Barclays last week launched what it says is the first index to synthetically replicate the performance of emerging-market local-currency bonds.
The banks says the EM Local Currency Bond Synthetic Replication Index will give investors liquid access to EM LC debt markets. Direct access to EM LC debt can be constrained by the complexities and costs associated with, for example, local custody and regulation, as well as reduced liquidity.
The new index seeks to address these issues by synthetically replicating EM-like returns using liquid developed-market instruments (to source duration exposure) and EM currency and credit overlays (to source the additional EM risk premium).
The index can provide non-dedicated EM investors with transparent, liquid EM bond exposure, while offering tactical investors a route for expressing a view or hedging underlying cash positions, says the bank. Barclays can offer long or short positions on the index and provide it in funded or unfunded format.
The UK firm is the index provider that usually creates such replication indices, say sources. But while such products can often provide lower-cost access to EM LC, sometimes the synthetic replication approach may produce performance that diverges from that of their underlying EM cash bond markets, says one Hong Kong indexing executive. However, Barclays says the tracking error is very low.
How does the bank deal with the low-liquidity issue of EM LC bonds itself when it comes to hedging its own exposure? The index is based on taking positions in liquid developed-market instruments, EM currency overlays and credit indices, says a bank spokesman, so hedging it does not require Barclays to take exposure to the LC bonds.
Where does the bank expect to see most demand for the index? “Given the ability to offer short positions, we are expecting to see interest from funds and real money accounts that are looking to hedge illiquid bond portfolios,” says the spokesman. “Fast money accounts could look to express market views without incurring high costs.”
The bank is not seeking to license the index to competitors, he tells AsianInvestor. “However, we are open to working with wrappers that would want to launch index products/ETFs by hedging the exposure with us.”
Providing synthetic exposure creates counterparty risk for the client – asked how much of an issue this is for clients, the spokesman says: “Clients could face Barclays on a total-return swap [TRS]. One way to keep counterparty risk low will be to take short-dated exposures and keep them rolling. For example, investors could enter into a monthly/quarterly TRS and keep rolling them.
“Alternatively, we can trade under a credit support annex," he adds. "Further, we could work with our funds teams to set up funds collateralised with high-quality collateral if there is significant client demand in this format.”
The index is based on the benchmark Emerging Markets Local Currency Government 10% Country Capped Total Return Index, which is designed to provide a broad measure of local-currency EM debt. The benchmark index includes 21 countries in Asia Pacific, Europe, the Middle East, Africa and Latin America. Country exposure is determined using the market value weight of the country’s index-eligible debt, capped at 10%.